Published: September 1, 2012

The New York attorney general is investigating whether some of the nation’s biggest private equity
firms have abused a tax strategy in order to slice hundreds of millions
of dollars from their tax bills, according to executives with direct
knowledge of the inquiry.

The attorney general, Eric T. Schneiderman,
has in recent weeks subpoenaed more than a dozen firms seeking
documents that would reveal whether they converted certain management
fees collected from their investors into fund investments, which are
taxed at a far lower rate than ordinary income.

Among the firms to receive subpoenas are Kohlberg Kravis Roberts &
Company, TPG Capital, Sun Capital Partners, Apollo Global Management,
Silver Lake Partners and Bain Capital, which was founded by Mitt Romney, the Republican nominee for president. Representatives for the firms declined to comment on the inquiry.

Mr. Schneiderman’s investigation will intensify scrutiny of an industry already bruised by the campaign season, as President Obama
and the Democrats have sought to depict Mr. Romney through his long
career in private equity as a businessman who dismantled companies and
laid off workers while amassing a personal fortune estimated at $250
million.

Some executives at the firms said they feared that Mr. Schneiderman, a
first-term Democrat with ties to the Obama administration, was seeking
to embarrass the industry because of Mr. Romney’s roots at Bain. Others
suggested that the subpoenas, which were issued by the attorney
general’s Taxpayer Protection Bureau, might be part of an effort to
recover more revenue for New York under state tax law. The attorney
general’s office does not have the power to enforce federal tax laws.

A spokesman for Mr. Schneiderman declined to comment.

The tax strategy — which is viewed as perfectly legal by some tax
experts, aggressive by others and potentially illegal by some — came to
light last month when hundreds of pages of Bain’s internal financial
documents were made available online. The financial statements show that
at least $1 billion in accumulated fees that otherwise would have been
taxed as ordinary income for Bain executives had been converted into
investments producing capital gains, which are subject to a federal tax
of 15 percent, versus a top rate of 35 percent for ordinary income. That
means the Bain partners saved more than $200 million in federal income
taxes and more than $20 million in Medicare taxes.

The subpoenas, which executives said were issued in July, predated the
leak of the Bain documents by several weeks and do not appear to be
connected with them. Mr. Schneiderman, who is also co-chairman of a
mortgage fraud task force appointed by Mr. Obama, has made cracking down
on large-scale tax evasion a priority of his first term.

As a retired partner, Mr. Romney continues to receive profits from Bain
Capital and has had investments in some of the funds that documents show
used the tax strategy.

The campaign issued a statement saying that Mr. Romney did not, however,
benefit from the practice. “Investing fee income is a common, accepted
and totally legal practice,” said R. Bradford Malt, a lawyer for Mr.
Romney who manages his family’s investments and trusts. “However,
Governor Romney’s retirement agreement did not give the blind trust or
him the right to do this, and I can confirm that neither he nor the
trust has ever done this, whether before or after he retired from Bain
Capital.”

Managers at a typical private equity firm or hedge fund collect from
their investors management fees based on the size of the fund. But most
of their compensation comes as a share of the profits earned by the
fund. The Internal Revenue Service allows those profits to be considered
“carried interest,” taxed at the capital gains rate typically reserved
for investments.

The tax strategy used by Bain and other firms to convert management fees
— the compensation normally taxed as ordinary income — into capital
gains is known as a “management fee waiver.” The strategy is widely used
within the industry: 40 percent of the 35 buyout firms based in the
United States surveyed in 2009 by Dow Jones said their partners used at
least some of the firm’s fees to make investments in their funds.

But some prominent firms appear to avoid the practice. The Carlyle Group
and Blackstone Group have stated in regulatory filings that their
partners have not diverted management fees into investments in their
funds.

In the varied world of private equity, some firms may have lawyers who
are not aware of the strategy or have steered their clients away from
it, said a lawyer at one firm who has used the strategy for his clients.
Others, he said, may not have the operational capabilities to handle
the complex transactions.

Apollo Global Management, the buyout firm co-founded by Leon Black and
now publicly traded, is among those that use the conversion strategy.
Between 2007 and 2011, Apollo converted more than $131 million in fees
into investments in its funds, according to S.E.C. filings. A spokesman
for the firm declined to comment.

Likewise, K.K.R. converted more than $180 million in fees between 2007
and 2009, according to its filings. Kristi Huller, a spokeswoman for the
firm, declined to comment about any regulatory matter, but said in an
e-mail that K.K.R. had not used the tax strategy “for the past few
years.”

Other firms that received subpoenas include Clayton, Dubilier &
Rice; Crestview Partners; H.I.G. Capital; Vestar Capital Partners; and
Providence Equity Partners. Representatives for all these firms declined
to comment.

Tax lawyers have justified the arrangements by arguing that converting
the management fees into carried interest, which could lose some or all
of its value if a fund does poorly, entitles the managers to the lower
capital gains rate, which is intended to help mitigate the risks taken
by investors.

“They’re risking their management fee — they’re giving up the right to
that management fee in any and all events,” said Jack S. Levin, a
finance lawyer whose firm has represented Bain on some matters. Mr.
Levin said he did not consider the practice risky or even aggressive.

“The I.R.S. has known that private equity funds have been doing this for 20 years,” he said.

In 2007, the agency began taking a closer look at suspected tax abuses
at hedge funds and private equity firms. In a statement at the time, an
I.R.S. spokesman said that management fee conversions were among several
“areas of possible noncompliance.” But no formal ruling appears to have
emerged.

Some private equity firms take what tax experts consider a less
aggressive approach to the conversions, waiving fees on all of a given
fund’s investments over the lifetime of the fund, which can be 10 years.

But other firms choose which funds or even which particular investments
to waive fees on frequently, like every year or every quarter. Such
arrangements may allow the executives to apply the waiver only when they
believe their funds are more likely to appreciate in value,
substantially reducing their investment risk.

Mr. Schneiderman is also looking at whether private equity executives
treated management fees as a return of invested capital — potentially
escaping taxation entirely — or deferred payouts of the converted fees
in ways that improperly reduced their tax liabilities.

Executives at three of the firms subpoenaed by Mr. Schneiderman, who
asked for anonymity because they were bound by confidentiality
agreements, said that disclosures to their investors clearly stated that
the waived fees were allocated equally to all the investments in a
fund.

The leaked documents show that Bain has in recent years waived
management fees in at least eight private equity and other funds,
including one formed as early as January 2002. The documents stated that
Bain executives had the right to decide either annually or each quarter
whether to waive some or all of their management fees; they also had
the ability to convert the waived fees into investments in particular
companies held by the funds.

Victor Fleischer, a law professor and finance expert at the University
of Colorado who has been critical of the tax rules for private equity
firms, said he believed Bain had waived management fees into investments
with so little risk that the arrangement would not qualify for the
capital gains rate if challenged by the I.R.S.

“There is a tension between economic risk and tax risk that is supposed
to be inversely proportional,” Mr. Fleischer said. “The way Bain set it
up there’s not much risk at all, so it’s hard to see how this income
should receive capital gains treatment.”

Michael Luo contributed reporting.

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